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Quality Munis Don't Default? Not So Fast

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High-quality municipal bonds do not default. That has been the paradigm for several decades.

Richard Ciccarone, who heads research at McDonnell Investment Management LLC, thinks it is a paradigm soon to be tested.

At the Standard & Poor's/Bond Buyer Mid-Year conference on the State of the Tax-Exempt Market yesterday, Ciccarone presented the case for a "structural" and "long-lasting" change in municipal credit.

"The long-term picture for municipal credit quality is changing," he said. "The credit turf is getting riskier."

Ciccarone distinguishes between a temporary uptick in defaults stemming from a recession that is well into its second year and a new texture, color, and timbre in municipal credit.

He sees an asset without the crutch of triple-A bond insurance facing a number of impediments in the long term, and not just during this economic contraction.

While the Standard & Poor's Case-Shiller Home Price Index is down about 30% since its apex in 2006, real estate valuations - which form the basis of property tax assessments - have yet to catch up.

Ciccarone sees lower home values hampering tax receipts for years to come.

State and local governments have more than a trillion dollars in costs such as pension liabilities that will have to be borne by future taxpayers.

Many states have high fixed costs and hefty, off-balance-sheet commitments to localities and school districts.

Ciccarone sees these factors conspiring against governments to force "a gradual upturn in the incidence of municipal defaults in the long term."

The perception of municipal credit as ironclad is rooted in history: the default rate on triple-A munis from 1970 to 2006 was zero, according to Standard & Poor's and Moody's Investors Service.

Depending on the timeframe used to examine defaults, though, the rate could be higher.

At the peak of the Great Depression in 1935, as many as 3,252 municipal entities were in default, according to a 1962 study by George Hempel. Even a state general obligation bond - Arkansas - went into default.

Almost half of these credits were rated triple-A prior to 1929. At the time, conventional wisdom treated munis on par with sovereign bonds, Ciccarone said.

Ciccarone believes that just as the rating agencies and bond markets were caught off guard by municipal defaults in the first half of the 20th Century, they may be caught off guard in the years to come.

The zero default rate on top-quality munis encompasses a period of extraordinary growth and prosperity.

If the U.S. suffers from slower growth in the coming years, the zero default rate may no longer be applicable, according to Ciccarone.

At the conference yesterday, George Friedlander, muni strategist at Morgan Stanley Smith Barney, recognized a likelihood of "credit bombs," and their potential to scare away investors.

Philip J. Fischer, municipal strategist at Bank of America-Merrill Lynch, took a more moderate approach. He foresees more defaults because of the economic downturn, not because of a structural change.

He thinks municipalities will mostly avoid default because they need the bond market.

When Fischer used to teach corporate finance, he said he would challenge his students to consider why a company that borrowed money did not simply keep it.

The idea was that the cost of default outweighed the cost of repayment because of a financial calculation, not an aesthetic one.

This is true to an even greater extent for municipalities, Fischer said.

The ability of a municipality in default to "function and achieve public policy is severely inhibited," he said. "Access to the bond market is much more important in the public sector than the private sector."

Fischer said it is important to identify states that have tax receipts that are under threat in a recession.

He ascertains this by calculating a state's "beta." Beta normally refers to an investment's correlation to the broader financial markets, such as how a stock behaves relative to the Standard & Poor's 500.

In this context, Fischer uses beta to express how a state's tax receipts correspond to changes in the economy.

California, with its heavy reliance on income taxes on the wealthy, has the highest beta of any state, with 1.7. This means that when gross domestic product shrinks by 1%, California's tax receipts shrink by 1.7%.

"The impact varies dramatically across the country," he said.

Two months ago, Moody's assigned a negative outlook to the entire tax-backed local government sector nationwide.

The rating agency, remarking on 89,000 issuers with $2.2 trillion in debt outstanding, said perhaps the most important indicator of credit quality is the ability to cut expenses.